April 2022 – Stablecoins and CBDCs

Terra’s downfall aroused a bag of questions about Stablecoins – the haven of digital assets during periods of high volatility. From El Salvador adopting $BTC as a legitimate currency to countries embracing blockchain with the creation of CBDCs. We can see a large-scale usage of blockchain in enhancing the current financial structure across multiple monetary bodies. In this month’s newsletter, we will dwell on the world of stable assets. We are not covering the recent incident that happened with Terra and UST as we feel there is a lot more to find out about it.

What are stablecoins and CBDCs?

Payment infrastructures were being pivoted towards digitization steadily. COVID-19 acted as a catalyst for rapid expansion. Cryptocurrencies have outgrown other safe and transparent digital payment systems, notably in the last 2 years.
A stable digital currency should meet these conditions:

  • Stability of the asset to which it’s pegged
  • Liquidity of that asset
  • Transparency

1. What is a stablecoin?

It is a cryptocurrency backed by collateral or an algorithm such that it maintains a price peg.
There can be multiple types of stablecoins, such as

  • Collateralized stablecoin
  • Algorithm-based stablecoin
  • Part collateralized and part algorithm-based.

Types of collateralization for collateralized stablecoins:

  • Fiat backed
  • Crypto backed
  • Non-crypto and non-fiat-based asset-backed
  • A mix of all the above

2. What is a CBDC?

CBDC-Central Bank Digital Currency is a digital currency pegged to the value of the country’s fiat currency that issues it.

Further Classification of Stablecoins & CBDCs

Stablecoins

Stablecoins can be differentiated based on their foundation for stability. 

Collateralized Stablecoin

It is a stablecoin completely backed by collateral held in reserve. Bank-like entities hold the reserves for this type of stablecoin. Regular audits ensure there is no disparity between the amount stored in reserve and the stablecoins in circulation. 

Working

  1. A user deposits his fiat currency in a central entity like a bank/ exchange.
  2. An equivalent amount of the deposited amount gets minted as stablecoins
  3. While redeeming, the stablecoins get destroyed from the chain. An equal amount gets transferred to the user’s bank account.

Example: Tether, USDC

Rebasing Algorithmic Stablecoin

It is a stablecoin that maintains its price peg using decentralized algorithms. Manipulation of the supply of tokens is done via algorithms to maintain a stable price peg. 

Working

  1. An increase or decrease in the price of the stablecoin triggers the change in the supply of the tokens.
  2. The amount of tokens in each wallet is increased or decreased depending on the price of the stablecoin
  3. The effective percentage of the total supply stays the same
  4. The price disparity comes with an arbitrage opportunity
  5. Arbitrage opportunities ensure the price peg maintenance

Example: Ampleforth, Base Protocol

Seigniorage Algorithmic Stablecoin

Seigniorage = (Value of the asset) – (Cost of production & distribution of the asset).

This model follows a multi-token system that incentivizes people to maintain the peg of the stablecoin. One token gets pegged to a stable value, and the other tokens incentivize the users to maintain the peg.

 Working(Explained considering a 2 token system)

 $TS= Stablecoin, $TI = Incentive token

  1. $TS can be minted using $TI, and by burning $TS, $TI can be obtained
  2. If $TS wanders from the price peg, an arbitrage opportunity arises
  3. Arbitrage opportunities ensure the price peg maintenance
  4. $TI should have some inherent utility for the whole system to work smoothly.

Example: Basis Cash, Terra Stablecoin

Fractional Algorithmic Stablecoin.

The best qualities of collateralized and algorithmic stablecoins are used here to maximize capital efficiency. Fiat-backed stablecoins partially collateralized these. The other part acts as an incentive for driving the ecosystem.

TCR – Target Collateral Ratio
ECR – Effective Collateral Ratio
TCR is the collateralization ratio required to bring the price near its peg.
ECR is the ratio of the fiat-backed stablecoin to the secondary token distributed. 

Working

  1. The variance from the peg price brings about a change in the collateral ratio.
  2. If the price of stablecoin goes above the peg, the collateral ratio decreases, bringing the price back to the peg.

Example: FRAX, Iron Finance

Over Collateralized Stablecoin

The collateral in the case of this stablecoin is high compared to the traditional fiat reserve stablecoin. The price is maintained by burning and minting the stablecoin.

Working

  1. Crypto collateral is deposited to mint the stablecoin, the collateral is higher than the stablecoin mint quantity.
  2. In case the price of the collateral crypto falls, a proportional amount of stablecoin must be paid to avoid liquidation.
  3. In case the price of the collateral crypto rises, more stablecoins can be minted by the user.

Example: DAI

Source: Coin98

CBDC

Based on the purpose, CBDCs are further classified.

Wholesale CBDC model

These CBDCs act as the primary reserve for the central monetary authority of a nation. This model helps take a macro approach to the nation’s economy. It provides a framework to influence the interest rates directly, implement economic policies, and control inflation at cheaper infrastructure costs.

Retail CBDC model

This model caters to regular individuals and businesses. It is a government-backed digital currency. Due to this, the intermediary risk banks and other financial entities bring about is reduced. Thus, it ensures the safety of the user’s assets in case of bankruptcy of these intermediaries.

CBDCs are further categorized based on transaction verification

Account-Based CBDC

This method provides proof of a user’s identity. The transactions get mapped to the payer and recipient. The responsibility for maintaining these identities falls on the central monetary authorities of the nation implementing it.

Token-Based CBDC

This model works on the public-private key pair combined with digital signatures. It adds a factor of privacy to CBDCs along with challenges related to money laundering.

Current scenario

The pandemic’s onset led to problems like supply chain restrictions and the printing of money into the economy, leading to an increase in inflation. The US experienced an inflation rate of 7.5%, the highest in the past 40 years. The lower interest rate incentivized the US consumers to borrow, leading to total debt of $15.6 Trillion in 2021.

As a remedy for inflation, interest rates will increase, leading to credit defaults. Thus, consumers would get liquidated to fulfill their debt obligations. This chain of events will lead to a market-wide panic.
Cryptocurrencies and CBDCs are viable solutions to prevent the impending economic crisis effectively.

Stablecoins appeal to the masses

With a total market capitalization of $​​162 Billion as of the 23rd of May 2022, stablecoins have a fair share of interest from the general public and institutions. 

Source: CoinGecko

In times of volatility, users prefer to hold a stable asset to ride out the storm. There are 50+ stablecoins across different blockchains to cater to this need and meet the demand. The user activity can be ascertained from the daily trading volume: $48.5 Billion(Data as of 23rd of May 2022).

Brief Outline of the Top Stablecoins (By Market-cap)

Source: CoinGecko
Data as of 23rd March 2022

  1. USDT
    Issued by the Tether foundation, USDT contributes to the overall stablecoin circulation. Its pan blockchain availability adds to its feasibility and keeps the liquidity healthy. The tether stablecoin USDT is pegged to the USD in 1:1. The equivalent asset is stored in tethers central reserve. Recently, Tether has been under a lot of fire due to allegations about inaccuracies in their reserve pools. Despite this, USDT still holds its top spot in market capitalization.
  1. USDC
    Issued by Circle, USDC is the 2nd largest stablecoin in market capitalization as of 23rd May 2022. In 2018, in partnership with Coinbase, Circle launched the Center for governing the USDC stablecoin. USDC is pegged to the USD in the ratio of 1:1. USDC charges no fees on USD to USDC conversion. This is a possible reason for USDC’s rapid adoption rate. Circle’s partnership with VISA opened up access for USDC to over 60 Million merchants accepting VISA. 
  1. BUSD
    Issued by Paxos, BUSD is the 3rd largest stablecoins in market capitalization as of 23rd May 2022. BUSD is pegged to the USD in the ratio of 1:1. Similar to USDC, they charge no fees on the creation and redemption of BUSD. The popularity and large-scale adoption of Binance directly influence the wide-scale adoption of BUSD.
  1. DAI
    Developed by MakerDAO, $DAI is a decentralized stablecoin and the 4th largest stablecoins in market capitalization as of 23rd May 2022. $DAI is pegged to the USD in the ratio of 1:1, but fiat currencies do not collateralize it. Instead, $DAI uses crypto as the collateral with a multi-token collateral system.

Some mainstream companies attempt at stablecoins:

  1. Facebook’s (now META) failed attempt
    Facebook had been in the development of its cryptocurrency LIBRA. Due to concerns from authorities, $LIBRA was rebranded as $DIEM with the help of Silvergate Capital Corp. $DIEM was planned to be stablecoin backed by the USD. 
    Eventually, it was decided by the authorities to completely shut down the project, criticizing facebook’s allegedly unethical practices and denying them the power to manage a payment system.
  1. Paypal’s plan for a stablecoin 
    PayPal has been an active supporter of cryptocurrencies. In January 2022, PayPal came out with the announcement of the PayPal coin. A stablecoin pegged to the USD.

Source: Coin98

CBDC adoption by governments

Many governments are opposed to cryptocurrencies being used to barter within their economy. They believe that adopting cryptocurrencies would provide an easy path for avoiding taxes, carrying out money laundering activities, funding terrorism, etc. 

But the benefits of the technology outweigh the shortcomings. Thus, the governments have begun experimenting with CBDCs. Over 90+ countries have started experimenting with CBDCs. 

Source: Atlantic Council

China vs Cryptocurrencies

China was at the forefront in opposing cryptocurrencies.  They planned to eradicate cryptocurrency circulation in China entirely in a phased manner

This created a perfect path for China to introduce Digital Yuan, China’s CBDC. The project started in the year 2014 to challenge the dominance of the USD. 

India adopting CBDC

India has been on the opposite end of the crypto ecosystem. From RBI(Reserve Bank of India) banning crypto trades in 2018 to the Supreme Court of India relaxing the ban in 2020. 

A lot of speculation was seen on India’s stance on crypto in 2022, with the Union budget being announced in February. The Finance Minister of India, Nirmala Sitharaman, announced “Digital Rupee,” a CBDC issued by RBI to boost the Indian digital economy.

Other

  1. The United States is experimenting with CBDCs to improve its domestic financial infrastructure.
  2. In December 2021, Jamaica successfully minted its first batch of CBDCs.
  3. Countries like Sweden, Canada, Australia, and many more are experimenting with CBDCs.

Road Ahead/Conclusion

Globally, entities adapt to blockchain technology and utilize it to benefit their cause. For a country like the USA, it’s beneficial that the stablecoins backed by USD are being used and adopted globally. The global adoption directly helps the USD maintain its dominance in the international markets. Retail-wise, people are earning better APY using different DeFi protocols than other investment opportunities.

Developing countries have their doubts about the cryptocurrency ecosystem and the possible issues. Thus, they have adopted an alternate digital currency – CBDC. On a larger scale, CBDCs can prove to be a boon to the economy of developing nations and countries on the verge of economic collapse. CBDCs allow national entities to implement necessary policies to improve their economies affordably.

Experimentation would be of utmost importance to strike the perfect balance between the need for privacy and ease of use for choosing the proper vessels for boosting a nation’s economy.

Disclaimer: This article is a summary of the writers opinions and research. Digital assets are a volatile asset class and readers should be aware of the potential risks of investing in blockchain projects. This is not investment advice & we will not accept liability for any loss or damage that may arise directly or indirectly from any such investments.